Chief economist says future does not bode well for strategy and that different approaches are now required
The traditional 60/40 asset mix of stocks and fixed income may have served investors well since the early 1980s but the strategy is looking passé when forecasting the post-pandemic environment.
This warning comes from Todd Mattina, chief economist and senior vice-president at Mackenzie Investments, who has released a new report focusing on asset allocation in an uncertain economy.
His analysis suggested that to counter these changinfg times, investors could take advantage of new investment tools, such as absolute return strategies incorporating leverage and shorting to seek positive performance in rising or falling market conditions. In addition, Mattina said that actively managing the asset-allocation decision can not only add value but reduce risk by shifting the asset mix with evolving economic conditions.
While recognising that the 60/40 mix has delivered high risk-adjusted returns compared to long-term historical averages, and bonds have also provided strong diversification benefits while contributing outsized returns, Mattina said this was an “exceptional period” for investors that may not be repeated in the next decade.
He explained: “The outlook for the traditional 60/40 asset mix is less optimistic today because of low asset-class yields and heightened uncertainty about the post-pandemic economy. Equities and bonds tend to outperform when economic growth is higher than expected and inflation is lower than expected.
“During the ‘Great Moderation’ after 1980, the 60/40 portfolio delivered strong risk-adjusted returns owing to the secular decline in inflation and interest rates, which also supported a higher fair value for stocks. Disciplined portfolio rebalancing in periods of market stress was also rewarded with long-term gains. However, expected returns in the next decade for many asset classes have declined relative to history. Bond yields have reached near record lows while equity earning yields also point to moderate returns compared to the last decade.”
Mattina highlighted four possible economic environments characterized by higher vs. lower growth and higher vs. lower inflation, with each of these scenarios having different implications for asset class returns. He said that the 60/40 portfolio is expected to outperform in environments with higher-than-expected growth and lower-than-expected inflation. In contrast, the 60/40 is expected to under-perform in a “Stagnation” scenario with persistently low growth and in a “Stagflation” scenario with persistently high inflation and low growth.
He believes that a better balance of portfolio exposures to different asset classes can lead to a smoother ride through shifting economic conditions and that a prolonged Stagnation scenario would increase the chance that the traditional 60/40 asset mix under-performs in the next decade relative to historical performance.
“In this scenario, global output would recover more gradually than expected due to scarring from the economic lockdown, such as skills atrophy from prolonged unemployment and greater business failures as prolonged cash crunches lead to insolvencies,” he said.
“In this scenario, equity and credit markets would struggle while defensive assets like government bonds would outperform. Since equities are the dominant contributors to total portfolio risk and return, the traditional 60/40 portfolio would be expected to under-perform overall in this type of environment. Moreover, interest rates are already near record low levels, so the scope for a further decline in yields appears to be limited, suggesting that bonds may provide less effective diversification benefits going forward.”
A “Stagflation” scenario, meanwhile, would lead to weaker expected performance for the traditional 60/40 portfolio because nominal government bonds would also underperform due to higher inflation. The risk of rising inflation largely reflects aggressive economic policies unleashed in response to the most severe economic downturn since the Great Depression.
The result could be that, as the economy re-opens gradually for business, a slower-than-expected recovery with a rebound in money velocity triggers greater inflationary pressures.
Mattina explained: “Low growth and high inflation in this scenario would lead to weaker expected returns for both stocks and fixed income. In this type of environment, fixed income would fail to provide diversification gains. We believe that investors should consider active approaches for asset allocation to help navigate the shifting post-pandemic environment as well as alternative investment strategies to help achieve their investment goals.”
This doesn’t mean dismissing the value of fixed income, which still has a key role to play. “Stagnation” scenarios with lower-than-expected inflation and growth would likely result in a further decline in long-term bond yields.
He added: “With equities under pressure, fixed-income exposures would be expected to contribute positively to total portfolio returns when needed most. Canadian and US long-term bond yields are still in positive territory so there remains modest room for a further decline in yields in the event of a downturn. However, low bond yields imply that diversification benefits come at a higher opportunity cost today because of the lower expected contribution from bonds to total portfolio returns.”